What Is a Construction Contract?

A construction contract is a legal agreement, usually between a builder and an owner, that provides for a specified amount of compensation for completion of a construction project.

Construction contracts specify terms and conditions of a construction job, such as scope of work, project guidelines, compensation payment, timelines for execution, and penalties, if any, for the delay. They may also spell out the procedure for distribution of compensation.

Though there are many types of construction contracts, a few types are more popular among construction professionals.

Lump Sum Contracts

A lump sum contract is the most basic type of construction contract. It is also known as a stipulated sum contract. A lump sum contract requires the contractor to provide services for a fixed price specified in the agreement.

Since the contractor bears all the risks and contingencies, a lump sum contract usually offers a higher markup for the contractor. The contractor is responsible for proper execution of the project with his own means and methods.

The amount of compensation in a lump sum contract is usually determined by adding the profit margin to the estimated figure of labor, material, and overhead costs. The profit figure of the contractor varies, depending upon the actual cost of execution. The cost to the owner, however, remains the same.

A lump sum contract is appropriate for situations where the project is clearly defined, allowing for complete estimation of the project cost.

Unit Price Contracts

Projects in a unit price contract are broken down into several parts. The unit price of each item and the total number of items required in the project are calculated. The contracted price is determined based upon the number of items required to execute the project.

An agreement to paint, repair, or maintain a property on a per-square-foot price basis is an example of this type of contract.

Cost-Plus Contracts

In a cost-plus contract, the buyer agrees to pay the actual material, labor, and overhead cost incurred by the contractor, in addition to his profit. This type of contract is suitable for projects where the nature of work is uncertain or where there is a huge fluctuation in the cost of labor, material, and equipment involved.

The contractor's margin is fixed in a cost-plus contract. If the actual costs incurred are lower than estimated, the owner saves the money. Similarly, if the actual costs are higher, the owner bears the additional burden.

Cost-plus contracts usually deliver quality construction even if the cost involved is higher. There is less incentive for the builder to use low-grade materials because his profit remains unaffected by the material cost.

There are three major types of cost-plus contracts:

Cost-plus fixed percentage contracts, where the contractor's compensation is set as a percentage of the project cost.

Cost-plus fixed fee contracts, where the contractor's compensation is a fixed sum of money irrespective of the project cost involved.

Cost-plus fixed fee with guaranteed maximum price contracts, where the contractor's compensation is a fixed sum of money, but there is a rider to keep the overall project cost within a mutually agreed limit.

Incentive Contracts

In an incentive contract, contractor's compensation is linked to his performance, based upon the set targets of budget, schedule, or quality.

There are two major types of incentive contracts:

Fixed price incentive contracts, where the compensation is fixed.

Cost reimbursement contracts, where the agreed compensation is to be adjusted, depending upon the proportion of actual costs to the targeted costs.

Guaranteed Maximum Price Contracts

A guaranteed maximum price (GMP) contract is also referred to as a not-to-exceed price (NTE) or NTX contract. In this type of contract, compensation is based upon the actual cost plus a fixed sum of contractor's fee. However, the cost items are subject to maximum prices specified in the contract.

If the actual costs exceed the set ceiling prices, the contractor bears the difference. However, if the actual costs are lower than budgeted, the owner keeps the savings.

Some contracts may provide for sharing of savings between contractor and owner. This serves as an incentive to the contractor to keep the project costs low.

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